May 7
min read

Step by step guide To See If A Backdoor Roth IRA Is Right For You

Understand the ins-and-outs of a Backdoor Roth IRA.
Adrianna Adams, CFP®

Are you a high-income earner looking to maximize your retirement benefits? If so, a Backdoor Roth IRA may be a great option for you. Currently as of June 1, 20231, the income limits for contributing directly to a Roth IRA are $138,000 for single tax filers, and $218,000 for those married filing jointly with no reduction on the allowed contribution amount. However, this strategy allows an individual to fund a Roth IRA, even if they are above the income limits for a direct contribution. 

How does a Backdoor Roth IRA work?

Funding a Backdoor Roth IRA is similar to contributing to a normal Roth IRA, with one additional step. First, you’ll make a non-deductible contribution to a traditional IRA. Next, you’ll transfer these funds from your traditional IRA to a Roth IRA. Since you didn’t deduct the contribution from your income, there are no tax consequences to transfer the funds into your Roth IRA. However, if you have any existing pre-tax funds in a Traditional IRA, there may be tax consequences to making a Backdoor Roth IRA contribution - we’ll discuss this in more detail below.

Perks of a Backdoor Roth IRA

If implemented correctly, a Backdoor Roth IRA will allow you to enjoy all the benefits of having a Roth IRA. These advantages include:

1. Avoiding Income Limits: A Backdoor Roth IRA allows you to enjoy all the benefits of a regular Roth IRA, even if you exceed the income limits.. Do you expect your income level to be higher in the future, or during retirement? If so, this strategy could maximize your tax savings in the long-run. Income limits for a direct Roth IRA contribution change every few years, so it is important to know whether your current income level is within this threshold.

2. Tax-free Growth & Withdrawals: The money you invest in a Roth IRA grows tax-free. In addition, withdrawals from your Roth IRA will not be taxable as long as you wait until age 59 ½ and have met the 5 year holding requirement. This is a notable advantage over using a Traditional IRA, where all distributions are considered taxable income. 

3. No Required Minimum Distributions: Roth IRA’s do not require distributions at a certain age, meaning you can let your investments continue growing tax-free if you don’t need the money. 

In comparison, you must begin taking distributions from a Traditional IRA after a certain age. Some individuals may benefit from this flexibility, especially if they have other sources of income during retirement, or plan to retire later. For example, someone who plans on retiring later may wish to delay withdrawals from their retirement account if their salary covers their income needs.

Factors to Keep in Mind

Although a Backdoor Roth IRA offers many advantages, there may be draw-backs depending on your unique circumstances. Here are some important things to consider: 

1. Pro-Rata Rule: If you have any other pre-tax IRA balances (in a traditional, rollover, SEP or SIMPLE IRA), a Backdoor IRA conversion may trigger income tax. The taxable portion of the transfer is based on the ratio of pre-tax funds in the total balance of all of your IRAs combined (including pre-tax and after-tax funds). To avoid this consequence, you can roll all of the pre-tax funds into your 401(k) or employer-sponsored retirement plan before the end of the year. Luckily, money inside your 401(k) is not considered in the pro-rata rule, allowing you to efficiently make a tax-free backdoor Roth IRA contribution.

2. Tax Consequences: You may opt to convert all the funds in your existing pre-tax IRA(s) to your Roth IRA, allowing them to grow tax-free moving forward. Depending on the balance of your pre-tax IRAs and your current income situation, this may be beneficial, but it is important to consult a financial professional before making a decision. If you do owe any taxes on your Backdoor Roth IRA conversion, it is important to set aside sufficient funds in advance. It’s best to pay these estimated taxes quarterly to avoid any potential penalties and interest charges. 

So, Is a Backdoor Roth right for you?

Determining if a Backdoor Roth IRA is right for you depends on many factors. Remember that the information provided here is general, and individual circumstances may vary. Consulting with a financial professional at Domain Money will give you peace of mind, and the tools to make an informed decision. 


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